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December 15, 2013

Pros & Cons of Variable Distribution MLPs

The current yields of these master limited partnerships have been strong recently, but there are some cautionary factors to consider, Yorkville Capital notes

Master limited partnerships (MLPs) have proven their value in the asset allocation mix. As an asset class, they generate reliable, growing distributions for income investors. Plus, their mid- and long-term total returns have outpaced other investments such as REITs, utility stocks and the broad market indices.

“Instead of generally maintaining or increasing distributions, variable MLPs will pay out distributions each quarter that vary with quarterly cash flows of the business,” the report explains.

Second, variables can have a narrower business focus.

“The MLPs which have elected for the variable structures generally have single or few assets and often unhedged exposure to commodity prices,” according to Yorkville.

Third, they encompass a smaller number of partnerships than traditionals. There are 100 publicly traded MLPs but only nine of them are variables.

Otherwise, Yorkville notes, variables are essentially the same as traditional MLPs found in the energy pipeline business.

Both types of MLPs own U.S. energy assets, act as pass-through entities in which unit holders receive K-1s and trade on public stock exchanges.

Variables’ Origin

The report reviews variables’ history, which is important for evaluating the group’s performance.

The first variable, Terra Nitrogen (THN), a producer of nitrogen fertilizer, went public in 1994. The second, Dorchester Minerals (DMLP), emerged in 2003.

No new variables came to market between 2004 and 2011, when activity began to pick up.

There are now nine variables trading with a combined market capitalization of roughly $18 billion. It’s a concentrated industry.

Two companies, CVR Refining (CVRR) and Terra Nitrogen, account for about 47% of that market cap. And MLPs in two industries comprise over 80% of the total market cap: refining (45%) and fertilizer (38%).

The Investment Case

Variables’ past results are impressive, as the study notes:

Historical performance: Variables have outperformed traditionals in 8 of the last 10 years and the S&P 500 in 9 of the last 10 years.

Relative performance: On a rolling basis, variables have outperformed the broader MLP universe and the S&P 500 over one, three, seven and 10 years posting annualized returns of 35.4%, 48.1%, 35.6% and 35.6%, respectively.

Historical yields: Variables have averaged a 9.3 % yield, while MLPs overall have averaged around 7.5%.

Current yield: The average variable has a yield of roughly 14% vs. 5-7% for traditional midstream MLPs.

Market cap growth: From 2010 to 2013, the variable segment has increased from two to nine MLPs, while its market capitalization has grown at an annualized rate of some 110%, from roughly $6 billion to $18 billion.

Correlation: Variables have a correlation of only 0.37 to the broader MLP market and just 0.16 to the S&P 500. Correlation to the 10-Year Treasury was a negative 0.07.

Potential Downsides

These are impressive results, though there are several factors to consider when evaluating the numbers. Variables’ short history and concentration, both in largest companies and industries, means that the returns aren’t directly comparable to those generated by broad market indexes like the S&P 500.

As experts with Yorkville cautions: “Much of the structure’s history consists of a 1-2 member index, far too small to be statistically significant.”

Also, these aren’t buy-and-hold investments, especially for conservative income-investors. Historically, variables “have exhibited more risk than MLPs with monthly standard deviations approximately twice the MLP universe,” according to the report.

Where They Fit

Given that variables are further out on the risk-return spectrum than traditionals , how might you consider using them with clients?

Darren Schuringa, a managing director with Yorkville Capital, says that these MLPs can work well for active investors seeking exposure to a commodity and the economic cycle in one investment.

“Why wouldn’t you invest in an MLP that is going to distribute 100% of its cash flow?” he asks. “We know what happens when you get the commodity right, as well as the volume right: cash flows explode.

Thus, Schuringa adds, investors can get a “deluge of cash over the period of the expansionary cycle (when) commodity prices are rising and volumes are rising. You’re getting operating leverage and you’re getting price leverage. You’re going to get a lot of cash out of the investment and from what we’ve seen historically with the limited sample…”

In addition, the Yorkville managing director says investors can also “get similar price performance as you would get out of a C-corp but with much higher yield from this pass-through of income. So, you get better total returns, because you’re getting the same price performance but you’re getting much more income.”